A recent study in Financial Analysts Journal (FAJ) found that a portfolio of small-capitalization stocks is no more risky than a portfolio of large-capitalization stocks. And if the number of stocks in a small-cap portfolio exceeds 25 or so, that portfolio may be less risky than a large-cap portfolio. The authors compare volatility in two time periods, 1963 to 1984 and 1985 to 2008. In the earlier period, a portfolio of small-cap stocks was found to be significantly more volatile than the market, even for a portfolio of 50 equally weighted names, but in the more recent period, once a small-cap portfolio included 25 equally weighted names it was about as volatile as a large-cap portfolio. According to the authors, the reason for the decline in volatility of a portfolio of small-cap stocks relative to large-cap stocks can be explained by an increase in institutional ownership of large-cap stocks relative to small-cap stocks.
The takeaways for you are twofold. First, while small-cap stocks individually are often more volatile than individual large-cap stocks, that does not hold for a portfolio of small stocks (including 25-plus stocks). I would not advise conservative income focused investors to focus exclusively on small cap stocks, but adding a moderate number of small cap stocks to a portfolio can reduce risk. Second, many advisors rely on the diversification benefits of an asset, which are derived from historical correlations to justify investment in that asset. Remain skeptical of this approach. As the FAJ study shows, increasing investor participation in an asset can alter that asset’s return profile and erode its diversification benefits.
